We are economists writing about economics: Karl Smith, an assistant professor of economics and government at the School of Government at the University of North Carolina; and Adam Ozimek, an associate at an economics consulting firm. As most in our profession are eager to tell you, economics includes just about everything, so we'll be blogging -- with varying degrees of success -- about the economy, markets, politics, science, technology, philosophy and culture. We both come from a similarly vague libertarian ideological perspective, but we've been called neoliberal as well, and idiosyncratic might be the best adjective to use.

The Housing Recovery: A Rethink

I predicted since the Summer of 2011 that a housing recovery was building and that it would “kick” around April of 2012. That prediction was based on the assumption that collapsing vacancies and rising rents would fuel a boom in multi-family housing construction.

To date, multi-family has experienced a strong turn-around but is well short of the boom I had been calling for.

Overall, I overestimated the ability of the multi-family industry to go parabolic. Growth has been very strong –averaging around 50% Year-over-Year recently- but it appears to have stabilized in that strong range. That means that if things continued we could get roaring multi-family construction but it would not be until late this year or early next.

However, with that slow of a build up in multi-family I doubt the rest of the housing sector will sit idly by. And, indeed there is evidence that it is not.

With so little multi-family coming on the market, investment in single family homes for rent is becoming hotter and hotter. This, of course, was a part of the original prediction but I thought the roles would be reversed. Multi-family would lead and single family for rent would follow. Instead, single family for rent seems to be leading with multi-family following.

How does this change my view of the housing recovery?

It actually changes it quite a bit and the dynamics involved are complex but I’ll do my best to outline them here.

Investment in single family homes for rent is likely to have a “critical mass” property that I have described before. There are several reasons for this

As more investors move into single family homes they will stabilize the price declines and make it safer for other investors to get in.

As investment in single family homes for rent becomes more common banks will be better able to assess the risk associated with such and investment and investment loans will become easier to get and have lower interest rates.

As investment in single family homes picks up, the market will become somewhat liquid. This is as investor I will know that if I have a personal cash shortage I will be able to sell out to another investor for something close to fair-value with a relatively short waiting time.

In particular the third factor is by far the most important. If investors within a community begin to know each other and begin to establish informal standards by which they judge a property then these kinds of transactions will be able to proceed fairly rapidly. If the investment community is likewise thick then we could get a reasonably liquid secondary market in investment property.

Of course, housing will never be as liquid as something like securities because each house is unique. Nonetheless, there is currently an enormous liquidity premium attached to housing. The rent-ratio in most US cities is now less than 10%, which means that rental housing has a current gross yield of more than 10%.

That is compared to 1.73% for US Treasuries and 2.05% for the S&P 500. Like the S&P 500 the yield on rental housing represents a “real” yield. That is as inflation rises so will rents. Indeed, this is almost true by definition as rents are by far the largest component of core inflation.

Thus we should really compare both the S&P 500 and the yield on rental housing to the Inflation Protected Yield on Treasuries which currently around –0.4%. Yes, that minus sign is correct.

The net yield on rental housing is less than this as the landlord must pay for insurance, taxes, repairs and vacancy time. Even given those factors, the liquidity premium versus bonds is still enormous.

This implies that if the rental housing market suddenly became liquid the selling prices would shoot up.

Now, in reality I don’t think it will play out that way. Instead, the pressure to bring new properties on to the rental market will increase dramatically. This means that what is commonly called the “shadow inventory” in US housing will fall rapidly.

Investors will push to by large amounts of foreclosed properties and will pressure underwater homeowners to go for short-sales. I don’t know enough about the legal details to know what is permitted, but if it were not banned I would expect investors to begin setting up websites and brochures explaining to homeowners how they go through the process of a short-sale and arranging a quick turn-around for the bank.

This process will have significant effects on the overall economy. First, it will cool rising rents, so that instead of soaring prices we get slower growing rents.

This in turn will take pressure off the Federal Reserve to raise rates and will likely lead to easier money.

Second, it will facilitate further deleveraging even without an increase in household savings. Remember that foreclosures and short-sales are a major part of the deleveraging process. As long as mortgage is still on the books it counts as household debt whether or not there is a realistic chance for the homeowner to pay off the mortgage.

Third, it will cause a real increase in free household cash flow. Slower growing rents along with more homeowners getting out from under very large mortgage will mean more income left over for other purchases.

All of these factors put together suggest that we would see a rise in discretionary purchases, including cars, electronics and housing. I would have to think more about it, but my guess is that if the dynamic plays out this way would would see the strongest effects near the end of 2012, going into 2013 at the earliest.

There has to be some time for this entire chain to work through. Investor demand has to continue to pick up. A liquidity premium has to set it. That liquidity premium then has to lead to quick flush out of the shadow inventory. The flush out of the shadow inventory has to lead to more free household spending.

So, this is more or less my best guess going forward right now. That instead of a multi-family boom happening in the spring, we will get a massive collapse in shadow inventory sometime later in the 2012 and a resulting rise in personal consumption expenditures and residential investment.

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